Much has been discussed about renovating empty and distressed office buildings into viable multifamily dwellings. But successful adaptive reuse is more than targeting an empty office building and commencing renovations. Connect CRE recently spoke in depth with Waterton’s David Schwartz about the realities of these renovations, as well as his take on the multifamily sector, in general. Schwartz is the keynote presenter at the upcoming Connect Midwest: Multifamily & Adaptive Reuse Trends conference.

Connect CRE: What is your view about adaptive reuse and multifamily?

David Schwartz: Adaptive reuse makes sense under two circumstances. First, when the underlying asset becomes more or less distressed. And second, you can buy and renovate it at a cost that makes sense.

I think you’ll see more of this type of activity, especially given the distress in the office space right now.  You may be reading about office building owners giving the keys back to their lenders. Those will likely be the office buildings that will sell at material discounts to their costs, and that should create opportunity.

Municipalities are also interested in revitalizing these empty office buildings. Empty buildings don’t generate tax revenue. Because of that, municipalities are willing to create incentives for adaptive reuse developers. That’s happening in different ways. One is accelerated entitlements; a lot of these buildings aren’t zoned residential. You may also see some municipalities providing tax incentives, tax abatements, TIF districts and other economic carrots to encourage developers to go in and change the use.

High-profile cities like New York, Chicago, San Francisco and Los Angeles are currently talking about these types of incentives. At the same time, we’re starting to see sales at material discounts to the previous prices of these office assets. That may help drive this trend.

Connect CRE: What are some of the challenges when it comes to effective adaptive reuse?

David Schwartz: One main challenge is that not all buildings work for this purpose. It may not make sense to convert them to multifamily purposes. For example, their floorplates might be too big or bringing in the necessary mechanical infrastructure may be difficult and very expensive. There’s also the natural light issue to overcome. There are different theories about what percentage of the entire office stock is convertible, but my estimation is around 25% to one-third.

Another issue is location. A lot of these buildings are in central business districts that weren’t designed as live-work-play communities. They lack the important residential amenities like parks, schools, restaurants, grocery stores or nightlife. These CBDs were meant to serve people who work there during the daytime. The retail in the area might consist of breakfast and lunch places, and maybe a little shopping. But with COVID, the limited retail that was available closed down because of increasing work from home and the trend toward remote work. A lot of it has yet to re-open.

Because of this, municipalities may have to invest in more than economic incentives for any kind of adaptive reuse to work. They might have to create some residential drivers to bring the “play” component of urban living to these buildings.

Connect CRE: What’s your outlook for multifamily?

David Schwartz: Multifamily values peaked around Q1 2022, and they’ve declined anywhere from 15% to 20%, due to cap rate expansion. You have less debt capital available. Financing can be obtained through Fannie and Freddie and other sources, like the various life insurance companies. But it’s relatively low-leverage, with generally higher rates, so you’re seeing fewer transactions. Seller cap rates are moving up a bit, while buyer cap rates are even higher, so you have a classic bid ask spread.

I think the unknown is really the deceleration of the strong fundamentals we had coming out of the pandemic. Some of the markets with strong rent growth in 2021 and 2022 are seeing base rents go negative. That could put upward pressure on cap rates and exacerbate the bid-ask spread.

I also think there’s going to be quite a few loan maturities in the multifamily sector over the next three years, and some of those loans will be hard to refinance. But there’s still a lot of equity capital out there, so I don’t think you’re going to see profoundly distressed deals as in previous downturns. You’ll likely see good investment opportunities as some of the more stressed assets become available for sale.

Meet David Schwartz and other experts at the upcoming Connect Midwest: Multifamily and Adaptive Reuse Trends, which takes place June 13, 2023, at the W Chicago City Center. Click here for more information and to register.